China Law Insight : China Business and Intellectual Property Lawyers & Attorneys : King & Wood Law Firm : IP, Arbitration, Litigation, Securities, Foreign Investment

a) Increased Deemed Profit Rate

According to the Rep Office Tax Measures, there are only two ways to tax Rep Offices, the Actual Profit Method or the Deemed Profit Method.

The Actual Profit Method is subject to the ability of the Rep Office to properly record its operations in its financial accounting books and accurately calculate its taxable income and profit through proper reflection of the actual functions it performs and risks assumed and then report returns based on such records to the tax authorities on a quarterly basis.

The Actual Profit Method of Rep Office taxation is advantageous because, unlike the Deemed Profit Method, costs can be used to reduce taxable profits. However, if a Rep Office is unable to maintain complete accounting books, or cannot accurately calculate its returns or costs, the Rep Office will be taxed according to the Deemed Profit Method, which is based on the Rep Office’s costs or revenue. The selection will depend upon which amount can be more accurately illustrated by the Rep Office. The tax authority will designate a deemed profit rate to the Rep Office and calculate the taxable income based on such deemed profit rate.

By the Rep Office Tax Measures, the minimum deemed profit rate under the Deemed Profit Method was increased from 10 to 15 percent. It should be noted that the Rep Office Tax Measures only provide a minimum deemed profit rate so there is a chance that some local tax bureaus may decide to impose a higher rate.

b) Abolishment of Tax Exemption

The Rep Office Tax Measures repeals several previous tax regulations applicable to Rep Offices and therefore Tax Exemptions for Rep Offices have also been abolished.

In the past tax regulations previously applicable to Rep Offices include 1) regulations pertaining to a Rep Office's non-taxable activities, such as market research and information collection, 2) regulations providing for income tax exemptions for Rep Offices established by foreign governments and non-profit organizations, and 3) the specific rules relating to the classification of Rep Offices under the Actual Profit Method and Deemed Profit Method. As an alternative for the abolished tax exemptions, the Rep Office Tax Measures provide that a Rep Office at its own initiative can apply for such special tax treatment which may be applicable to the Rep Office according to tax treaties or agreements.

c) Liability for Rep Offices to pay Value-Added Tax (VAT)

The Rep Office Tax Measures also provide that, in addition to income tax and business tax, Rep Offices should also pay VAT, which generally applies to sales of goods. This new requirement is  ambiguous in that Rep Offices are prohibited from directly engaging in the sale of goods.
Regarding the administrative restrictions on Rep Offices, the State Administration for Industry and Commerce (SAIC) and the Ministry of Public Security jointly issued the “Notice Concerning Further Strengthening Administration of the Registration of Foreign Enterprise Permanent Representative Entities” (the “Rep Office Administration Notice") on January 4, 2010.

By the Rep Office Administration Notice the criteria for the grant or renewal of the authorization to open a Rep Office have also been tightened. Accordingly, a foreign company which seeks to set up a Rep Office must show that the foreign company has been set up at least for two years. In the case of a renewal the applicant will need to prove that the foreign company still exists.
Further a limitation has been introduced as to the term of new and renewed Rep Office licenses for one year at a time (compared to the usual three years).

Also the number of foreign representatives in a Rep Office has been affected by the Rep Office Administration Notice. According to the new provisions a maximum of four representatives, including the chief representative, are generally allowed in a Rep Office. The transitional provision for the existing Rep Offices with more than four representatives provides that the Rep Office cannot replace employees in excess of the limit. The limit, however, does not apply to the Chinese staff employed without powers of representation.

It appears that both the Rep Office Tax Measures and the Rep Office Administration Notice have been issued to restrict and discourage the establishment and maintenance of Rep Offices. To mitigate if possible the effects of the new heavier tax burden, existing Rep Offices are advised to investigate whether the Rep Office is still eligible for tax exemption under a treaty or other arrangements. In general the new regulations may be a good reason to consider whether an existing Rep Office should be closed and that it may now be the time to consider a WFOE which may now make even more sense from operational and tax perspectives. It seems in any event that the Chinese authorities are keen to have Rep Offices revert to their initial purpose (i.e. small window offices not actual businesses). Foreign companies wishing to actually do business in China may need to consider establishing a real legal entity.
 

On January 8, 2009, the SAT issued the Interim Implementing Rules for Special Tax Adjustments ("the Rules"), which was a major milestone in China's crackdown on tax avoidance. The Rules introduce the general anti-tax avoidance provision which empowers tax authorities to launch anti-tax avoidance investigations and make tax adjustments on transactions without reasonable business purposes, including treaty shopping, abusive use of tax havens or abusive use of tax treaty benefits. When determining whether a tax arrangement was made to avoid taxes, Chinese tax authorities tend to focus on the substance of the arrangement, no matter what form the arrangement takes. Before making such a decision, the tax authorities will perform a comprehensive examination on a number of factors, including the form and substantive impact of the transactions, the execution date and duration of implementation of the transactions, the transactional methods, the connections between each step of the transactions, and tax consequences.

On April 22, 2009, the SAT then released the Guidance on Establishment of Tax Residence Status for Chinese-controlled Offshore Companies under Effective Management Rules, (“the Guidance”) which had a significant impact on "red-chip" companies and round-trip SPVs. Pursuant to the Guidance, if a Chinese-controlled offshore company is regarded as effectively managed in China, then it would be considered as a Chinese tax resident company and taxed on its worldwide income at the rate of 25%. Accordingly, a red-chip company incorporated in a low-tax region, such as Hong Kong, may be subject to Chinese enterprise income tax on its worldwide income. However, a dividend distribution between a Chinese controlled offshore company and other Chinese resident companies will be entitled to tax exemption treatment.

PRC tax authorities have also tightened their control of offshore companies over their ability to enjoy tax treaty preferential treatments, as witnessed by the strings of regulations issued by the SAT. These regulations cover not only substantive rules such as interpretations of various treaty provisions, but also procedural rules as to how to apply for tax treaty benefits. They impose stringent requirements on the entitlement of treaty benefits for offshore entities. For example, under the Circular on Application of Dividends Provision of Tax Treaties issued by the SAT on February 20, 2009, applicants qualifying for preferential treaty treatment on dividends are subject to certain requirements. In particular, if a recipient of dividends intends to apply the dividend provisions of tax treaties which require a threshold of equity holding (generally 25% or 10%), then such recipient must be a company and must meet the aforesaid threshold both in shares and in voting rights at any time during the 12 months preceding the receipt of dividends. In addition, the SAT's Circular on Interpretation and Determination of Beneficial Owner under Tax Treaties ("Circular No. 601") directs local tax authorities to investigate whether an applicant satisfies the requirements to qualify as a beneficial owner, which is a pre-requisite to enjoying the benefit of reduced withholding tax on dividends, interest, royalties or capital gains under a tax treaty. According to Circular No. 601, a beneficial owner refers to an individual or any organization that has ownership and control over the income or the assets or rights generating the income. An agent or a conduit company is not regarded as a beneficial owner. A conduit company is a company established in a tax-exempt or low tax rate jurisdiction for the purpose of avoidance or reduction of taxes or the transfer or accumulation of profits, and where the company does not engage in substantive business activities like manufacturing, distribution or management.

The competent local tax authority examines whether a person or an organization is a beneficial owner case by case by reviewing the information provided by the taxpayer or through exchange of information protocols, if necessary. The Circular further lists seven types of unfavorable factors. Where any of these factors exist, an individual or an organization may not be recognized as a beneficial owner. Pursuant to these factors, many single-level offshore SPVs will be unlikely to satisfy the requirements for beneficial owners due to lack of substantive operating activities or unjustifiable business purposes.

In terms of procedural rules on applications for treaty benefits, the SAT issued the Administrative Rules for the Provision of Treaty Benefits to Non-residents (Trial) on August 24, 2009. The Rules introduce two different procedures - filing procedures and approval procedures, depending on the types of applications. Approval procedures apply to applications for treaty benefits of dividends, interest, royalties and capital gains. In other words, nonresidents shall make substantial disclosures, submit adequate supporting documents, and obtain the approvals of tax authorities in order to enjoy treaty benefits. Applications for other treaty treatment, such as business profits of permanent establishments or individual service provider, should be subject to filing procedures, under which the applicant or the party subject to withholding tax is required to submit documentation (including tax residency certificate). For the said reasons, it is critical for the applicants to proactively prepare such application documents to properly and sufficiently address the offshore company's economic substance and business purposes.

In practice, Chinese tax authorities published their decisions on two real cases – a Xinjiang case and a Chongqing case. These decisions are clear signals for the tightened scrutiny on offshore SPVs and offshore transactions. In the Xinjiang case, a Barbados SPV acquired shares in a Xinjiang joint venture and subsequently sold the shares for a gain, and tried to avoid withholding tax on capital gains by applying China-Barbados tax treaty provisions. However, the Xinjiang state tax authority rejected the Barbados SPV's eligibility to enjoy the treaty benefits on the ground that the Barbados SPV was not viewed as a tax resident of Barbados and the transaction through the Barbados SPV was for tax avoidance purpose. In the Chongqing case, a Singaporean investor contemplated disposal of its shares in a Chinese subsidiary and thus established an intermediate Singaporean company to hold the equity shares, and later sold the equity shares of the intermediate Singaporean company to a Chinese buyer to avoid paying capital gain tax in China. Chinese tax authorities disregarded the existence of the intermediate holding company in Singapore and imposed withholding taxes over the capital gains realized from the transfer of equity shares or the Singapore holding company.

Companies are advised to watch closely the changes in tax regulatory climate, review their holding structures and offshore transactions, particularly the positioning of offshore SPVs, to mitigate adverse PRC tax exposures and ensure the soundness of both tax compliance and tax efficiency.

According to Circular 601, a beneficial owner refers to a person or any organization that has both ownership and right of control over the income or the assets or rights generating the income. An agent or a conduit company is not regarded as a beneficial owner. A conduit company is defined as a company established in a tax-exempt or low tax rate jurisdiction for the purpose of avoidance or reduction of taxes or the transfer or accumulation of profits, and where the company does not engage in substantive business activities like manufacturing, distribution or management. No further guidance is provided as to what constitutes management activities and whether such activities must be carried out by personnel or may be conducted at board level.

The determination of beneficial owner is to be conducted on a case-by-case basis, based on information provided by the taxpayer when applying for treaty benefits. The Circular further states that the following factors would be unfavorable in determining whether a company is the beneficial owner of an item of income, without indicating how these factors are to be weighed:

(a) The applicant is obligated to transfer all or most of (such as more than 60%) income to   a resident of a third country (region) in the stipulated time period (such as twelve months upon receipt of income);

(b)  The applicant does not or barely engages in other operating activities except for holding the income derived from the assets or rights;

(c)  When the applicant is a company, the applicant’s assets, business scale and personnel could not reasonably match the income;

(d)  The applicant has no or little right of control or disposal of the income or its underlying assets or rights; nor does it assume any or hardly any risks;

(e)  The income is non-taxable or tax-exempt in the other contracting country (region), or even if it is taxable, the tax rate is extremely low;

(f)  The lender to a loan agreement that generates interest income has another loan agreement or deposit contract with a third party; the amount, interest rate, and the time of conclusion with respect to the third-party contract are similar to those of the first loan agreement.

(g)  The licensor to an agreement on copyright, patent, and technology licensing or transfer has a contract to obtain the rights by license or transfer from a third party.

It appears clear that a single purpose vehicle (SPV) set up for a single Chinese investment will not satisfy the requirements for beneficial ownership under the Circular. It is less clear whether a holding company that holds several investment subsidiaries, but does not have its own management personnel, would qualify as a beneficial owner. The local tax authorities appear to have considerable discretion to make that determination, given the broad statement in the notice that a beneficial owner should have substantive business operations, the lack of any weighting in the identified negative factors, and the fact that even a multi-investment holding company would trigger at least two of the criteria set out above, and perhaps one or two more, depending on how these criteria are interpreted.

Companies are well-advised to review their holding company structures immediately, and consider restructuring out of SPVs, assuming they need to take advantage of the dividend withholding tax exemption. Companies with multiple investment holding companies need to exercise caution before applying to distribute dividends, and may consider injecting personnel and operating assets into their holding companies, if feasible, while keeping alert to further developments in the actual enforcement of Circular 601.